“Chicken Little” Investing was a Killer
March 01, 2007Four straight calendar years of solid stock market returns have been achieved despite tremendous anxiety and dire predictions about the U.S. economy, the U.S. consumer and the U.S. dollar. Predictably, the print and electronic media have raised one “crisis” after another that pointed to the imminent decline or outright devastation of the financial markets. All the “smart money” was said to be going into hedge funds in a big way while everyone else seemed destined for extreme volatility and low returns for the foreseeable future. Chicken Little ruled the conventional wisdom and, as ever, the sky was falling.
But (and this is a tremendous "but" for long-term, disciplined investors) there is an old saying that bull markets “climb a wall of worry.” And what a climb it has been. From near the bottom of the market decline in early September 2002 (coincidentally just as the noise kicked into high gear about how terrible things were and would always be) the S&P 500 has increased 87.97%. The Dow Jones Industrial Average has climbed 80.93%. Good, old-fashioned, plain vanilla, publicly-traded stocks. For all their trouble, high fees and lack of transparency, the “smart money” hedge fund investors collectively returned 42.78% (as measured by the HFRI Fund of Funds Composite Index), just somewhat better than the Lehman Aggregate Bond Index at 17.91%. The doomsayers have been extraordinarily wrong for a good number of years now. Chicken Little is correct periodically, and for short periods of time, but it appears that once again, pessimism, in the great American capital markets experiment, can be a costly long term position.
However (and this is an important however for long term, disciplined investors), stock markets do not rise forever into the cosmos in a straight, or even mildly jagged, line. There will be pullbacks, corrections, and even recessions along the way. This does not bode well for what is becoming the conventional wisdom — the “Goldilocks” economy. This new way of thinking is meant to explain a number of contradictory economic indicators. For example, high budget deficits, low unemployment, reasonable inflation and a fairly weak dollar don’t tend to happen at the same time. Goldilocks says the economy is not too overheated as to need further Fed rate increases, but not too soft as to slide into recession. Etc., etc. Bottom line for Goldilocks is that things appear to be “just right” and can continue that way indefinitely with strong stock market returns and low volatility for the foreseeable future. With the benefit of hindsight, sentiment now appears to be shifting from Chicken Little to Goldilocks. This may be confirmed by the increasing flow of funds into equity mutual funds in 2006. Also, anecdotally, we are hearing from prospective clients that they are dissatisfied with their “low-volatility hedge funds” these days (not to mention that latest Florida condo they were going to flip) and want to consider more traditional investment managers.
At Brightworth, we believe that the best way to prepare for whatever the market gives us in the next cycle is threefold. First, recognize that none of us can predict the future. And, after years of studying the top investment managers, analysts and economists, we are convinced that none of them know the future either. Second, protect cash flow for the next five to seven years by using a diversified fixed income portfolio. A solid fixed income portfolio consisting of Treasury bonds, corporate bonds, municipal bonds, international bonds, inflation-indexed bonds, etc. should provide higher returns than cash, CDs and short-term instruments while protecting against much of the volatility that occurs in the financial markets. Third, take an optimistic view of the power of capitalism to increase wealth over time — use stocks as the growth engine of your long term portfolios. Investments that are not needed for cash flow in the next five to ten years should probably be invested in a disciplined equity portfolio that is diversified across markets and strategies. If history is any indicator, equity-type investments are your only hope for significant, long term, inflation-adjusted growth in your portfolio. But, it is your fixed income strategy that protects cash flow in the short-term so that you can weather the inevitable ups and downs of the stock market.
The new danger for investors is the complacency, and sometimes greed, that accompanies a multiyear bull market and the current Goldilocks thinking. Believing that the stock market will continue to go up, some will be tempted to try to get that extra return without protecting cash flow. Just at the wrong time in the cycle. Stick with your discipline or this is one fairy tale that could have a sad ending.
